BlackRock Battles CME Over Rule Segregating Swaps Collateral

CME Group, the world largest futures exchange, has opposed the segregation model since the CFTC first requested comments last year. Photo: Tim Boyle/Bloomberg

Aug. 11 (Bloomberg) -- A U.S. regulatory proposal to
protect individual swaps traders is gaining support from Wall
Street dealers, buyers such as BlackRock Inc. and LCH.Clearnet
Group Ltd., owner of the world’s largest clearinghouse for
interest-rate swaps.

The proposal, issued by the Commodity Futures Trading
Commission and required under the Dodd-Frank Act, governs
collateral in trades guaranteed by clearinghouses that stand
between buyers and sellers of derivatives. Under the plan,
clearinghouses would be prohibited from drawing on the
collateral of a non-defaulting client when another client’s
downfall results in their broker’s default.

Support is coalescing behind the proposal after more than a
year of debate, two daylong CFTC roundtables, 40 meetings
between industry and agency officials and at least 50 letters
commenting on how to protect collateral in the $601 trillion
swaps market.

“There is not unified opposition to it on the dealer or
sell side or the clearinghouse side such that there is going to
be such strong pushback that we don’t end up there,” Joel S.
Telpner, a New York-based partner at Jones Day who represents
clients supporting the proposal, said in an interview.

Dodd-Frank seeks to reduce risk and boost transparency by
having most swaps guaranteed by clearinghouses and traded on
exchanges or other platforms. The parties in such trades are
clearinghouses, brokers that are members of and capitalize
clearinghouses, and the brokers’ trading clients.

Citigroup Inc. analysts estimated in July that 60 percent
of the global bilateral derivatives market will eventually be
eligible to be processed by clearinghouses.

Dodd-Frank

The financial-overhaul law was enacted by President Barack
Obama last year after largely unregulated trades helped fuel the
2008 credit crisis. After the default of Lehman Brothers
Holdings Inc. that September, hedge funds and asset managers
that were clients of the securities firm lost billions of
dollars because their collateral wasn’t segregated.

Last November, the CFTC asked buyers, sellers and
clearinghouses to respond to four proposals for protecting
collateral. In April, the CFTC proposed adopting a system, known
as “complete legal segregation,” which it described as a
compromise between requiring entirely separate collateral
accounts and pooling all collateral.

The proposal would require clearinghouses and brokers to
keep records tracking each client’s collateral while allowing it
to be managed in a single account. If a broker defaults, the
clearinghouse couldn’t tap the collateral of a broker’s non-defaulting client in an effort to guarantee the trades.

‘Most Appropriate Choice’

The proposal is “the most appropriate choice” and “an
important first step in arranging appropriate customer
protections,” Robert Pickel, executive vice chairman at the
International Swaps and Derivatives Association Inc., said in an
Aug. 8 letter to the CFTC. The association represents the
world’s largest swap dealers, including JPMorgan Chase & Co.,
Deutsche Bank AG and Morgan Stanley.

A clearinghouse should “never rely” on a non-defaulting
client’s collateral to cover broker positions, said Ian Axe,
chief executive officer of LCH.Clearnet. It is “possible if not
highly probable” that a non-defaulting client would have
already sought to move its collateral out of the clearinghouse
by the time a broker defaults, Axe said in a letter to the CFTC.
LCH.Clearnet, which is majority-owned by banks, is the largest
clearinghouse in the $364 trillion global interest-rate swaps
market.

BlackRock, Fidelity

The plan also found support among large trading clients and
swap-buyers, such as BlackRock, Fidelity Investments, Freddie
Mac, and two trade groups -- the Investment Company Institute,
which represents mutual funds, and the Managed Funds
Association, which represents hedge funds.

The CFTC plan “would protect customer collateral from
fellow customer and other risk without imposing undue costs on
market participants,” BlackRock’s Joanne Medero, head of
government relations, said in an Aug. 8 letter. The letter was
also signed by Richard Prager, managing director and head of
global trading, and Supurna VedBrat, managing director and co-head of electronic trading and market structure.

The CFTC may still revise the rule, and could even decide
to allow more than one collateral system for clearinghouses. The
agency is aiming to complete most Dodd-Frank rules by the end of
the year; no meeting has yet been set to finalize the rule.

Not all brokers and clearinghouses support the CFTC
proposal, according to letters filed with the CFTC before the
official comment period closed this week.

Futures Method

CME Group Inc., the world’s largest futures exchange, has
opposed the segregation model since the CFTC first requested
comments last year, arguing that the agency should base its
regulation on the method it currently uses to clear futures
trades.

Futures are derivatives that are exchange-traded and
cleared and have been regulated by the CFTC for decades. Before
Dodd-Frank, swaps were largely exempt from CFTC rules and traded
directly between buyers and sellers often in non-cleared
transactions.

Under the futures model, a client’s collateral is tracked
by clearinghouses and kept in a single account. If a clearing
broker defaults, however, the clearinghouse can tap collateral
from all of the broker’s clients to continue to guarantee
trades.

To add more protection for clients, CME has proposed CFTC
adopt a futures model with an “opt out” option.

‘Opt Out’

A system that “allows those swaps customers that are most
concerned to secure such protections to ‘opt out’” is the
“only approach” that will guard against fellow-customer risks
without imposing high costs on clearinghouses, Craig S. Donohue,
CME Group chief executive officer, said in the letter.

Newedge USA LLC, the largest futures broker by customer
funds, $21.6 billion as of June 30, and DRW Trading Group, a
Chicago-based proprietary trading firm, also opposed the CFTC’s
proposal, citing an increase in costs for clients.

“To the extent clearinghouses will not be able to rely on
the pool of non-defaulting customer collateral in the event of a
clearing member default, they will look to make up that
shortfall elsewhere,” Gary DeWaal, Newedge’s senior managing
director and general counsel, and Donald Wilson, DRW’s president
and chief executive officer, said in the letter.

The debate over costs may lead the CFTC to provide the
industry with some flexibility to choose among different
systems, said Ed Tracy, a principal at Deloitte Consulting LLP
and co-head of the derivatives team.

“There may be a middle position going from legal
segregation to futures,” Tracy said in a phone interview.